*Lipper's Losses Tarnish the Luster Of Convertible-Bond Hedge Funds
By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL
Just a month ago, the convertible-bond market was one of the last holdouts of safety and big returns on Wall Street.
No more. In light of a sudden $315 million write-down of the value of high-profile convertible hedge funds run by Lipper & Co., some investors now fear the market may be hitting a wall.
Sharp declines in the stocks of companies like Enron Corp., Tyco International Inc. and XO Communications Inc. have reverberated into the convertible-bond world, prompting investors in hedge funds like Lipper's to begin questioning whether their own funds could be valuing their holdings much higher than they should be.
"There is a lot of pain to come in the convert market because too many people have extended themselves and used leverage, and there are a lot of new entrants to the market that shouldn't be there," said Jamie O'Brien, managing partner at Promethean Asset Management, a New York hedge fund. "There's got to be a shakeout, and this Lipper situation might set it off."
In recent years, investors shifted into convertible bonds because they seemed like safe havens. Set up as bonds that could ultimately be converted into stock if the price hit a certain level, these so-called converts offered investors a guaranteed interest rate, as well as stock once companies began to take off.
Hedge funds like Lipper's usually went even further to protect themselves; they bought the convertible bonds, then sold the same company's stock short -- giving them a hedge if the company ran into trouble.
For a time, the strategy worked. Last year, the average return of such convertible hedge funds was about 14%, according to CSFB/Tremont, even as the stock market tumbled. Now, about 70% of the entire convertible market is owned by hedge funds, according to analysts.
But with so much new money coming into the convertible market, it has gotten easier for companies -- sometimes troubled companies -- to raise money selling such converts. Many lower-rated telecommunications, energy and other companies came to the market to raise money. These lower-tier companies sold convertibles at super-slim interest rates, sometimes 5% or 6% or lower, even as junk-bond investors often were demanding yields topping 12% for the bonds of these same companies.
To the issuing companies, convertibles were relatively risk-free, since they assumed they would only have to pay interest on the converts until their stocks hit the conversion price. Even if the stocks didn't rise, they had raised money at slim costs.
The result: Last year saw a record $102 billion in new convertibles sold, up from $52 billion in 2000 and just $15 billion in 1995. The booming market helped the bottom line at Wall Street firms, which have seen fees from underwriting initial public offerings shrivel.
But now, many of those riskier companies that sold convertibles are struggling, and investors who focused on this second-tier part of the market -- like Lipper & Co. -- are facing huge losses. Behind the losses: Shares have plunged, so the trigger price that was to have converted the bond into equity is so far out of the money that the converts look like nothing more than bonds of risky companies that carry skimpy yields.
Convertible bonds are down about 5% so far this year, according to a Morgan Stanley index, about the same losses as stocks. But convertibles for junk-bond rated companies -- a full 36% of the market -- are down 13% since September, even as investment-grade convertibles are down just 1% in the period, according to Convertbond.com. Since so many hedge funds use leverage to invest, their losses from this slice of the market are even larger.
Already, issuance has begun to dry up. In January, $10.7 billion of new converts were sold, a busy month. But so far in February, just $3.3 billion of these securities have been sold, the slowest month since December 2000, excluding last September's totals.
The question for Lipper, and for the rest of the convertible-bond market, is how many investors in the Lipper funds will move to withdraw their investments in the days ahead, on the heels of the markdowns. That could force Lipper to dump more than $1.7 billion of its remaining convertible positions, potentially causing more losses in the market.
Already there are signs that some investors are taking money out. On Wednesday, when investors received a letter from Lipper describing the write-downs, one large institutional investor sent a letter asking to redeem his firm's investment in the convertible fund, according to someone familiar with the situation.
The Lipper funds, like many hedge funds, don't allow investors to withdraw their money on a daily basis. But Lipper has told investors it will allow them to exit the fund until March 15.
"So far we've seen very little" in the way of redemptions, said Abraham Biderman, an executive vice president at Lipper. "But it's early. They still have time."
A bigger issue for the convertible market, and for the growing number of hedge funds that deal in the sector, is the worry that investors will turn away from the sector, worried that more firms may be holding securities at unrealistic prices.
On Friday, some hedge funds moved to reassure their investors that they were accurately pricing their positions. Many have begun to use independent parties to price their portfolios.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com
Updated February 25, 2002 10:56 a.m. EST |
